Many companies issue pro-forma financial statements in addition to generally accepted accounting principles (GAAP) -adjusted statements as a way to provide investors with a better understanding of operating results. In legitimate cases, pro forma financial statements take out one-time charges to smooth earnings. However, companies can also manipulate their financial results under the guise of pro-forma financial statements to provide a picture that is rosier than reality. Let's take a closer look at what pro-forma financial statements are, when they are useful and how companies can use them to dupe investors.

What Are Pro-Forma Earnings?Pro-forma earnings describe a financial statement that has hypothetical amounts, or estimates, built into the data to give a "picture" of a company's profits if certain nonrecurring items were excluded. Pro-forma earnings are not computed using standard GAAP and usually leave out one-time expenses that are not part of normal company operations, such as restructuring costs following a merger. Such an expense can be rightfully viewed as a one-time item that does not contribute to the company's representative valuation.

Essentially, a pro-forma financial statement can exclude anything a company believes obscures the accuracy of its financial outlook, and it can be a useful piece of information to help assess a company's future prospects. Every investor should stress GAAP net income, which is the "official" profitability determined by accountants, but a look at pro-forma earnings can also be an informative exercise.

Pro forma earnings figures are inherently different for different companies. There are no universal guidelines that companies must follow when reporting pro forma earnings, which is why the distinction between pro forma and earnings reported using GAAP is very, very important.

GAAP enforces strict guidelines that companies must follow when reporting earnings, but pro forma figures are better thought of as "hypothetical," computed according to the estimated relevance of certain events and conditions experienced by the company. Basically, companies use their own discretion in calculating pro forma earnings, including or excluding items depending on what they feel accurately represents the company's true performance.

For example, net income does not tell the whole story when a company has one-time charges that are irrelevant to future profitability. Some companies therefore strip out certain costs that get in the way. This kind of earnings information can be very useful to investors who want an accurate view of a company's normal earnings outlook, but by omitting items that reduce reported earnings, this process can make a company appear profitable even when it is losing money. We like to call pro forma the "everything-but-the-bad-stuff earnings."

The problem, however, is that there isn't nearly as much regulation of pro-forma earnings as there is of financial statements falling under GAAP rules, so sometimes companies bend or even abuse the rules to make earnings appear better than they really are. Because traders and brokers focus so closely on whether the company beats or meets analyst expectations, the headlines that follow a company's earnings announcements can mean everything. And, if a company missed non-pro-forma expectations but stated that it beat the pro-forma expectations, its stock price will not suffer as badly; it might even go up - at least in the short term.Problems with Pro FormaDespite the positive reasoning behind pro-forma statements, there are many ways in which pro-forma earnings can be manipulated. Items often left out of pro forma figures include the following: depreciation, goodwill, amortization, restructuring and merger costs, interest and taxes, stock-based employee pay, losses at affiliates and one-time expenses. The theory behind excluding non-cash items such as amortization is that these are not true expenses and therefore do not represent the company's actual earnings potential. Amortization, for example, is not an item that is paid for as a part of cash flow. But under GAAP, amortization is considered an expense because it represents the loss of value of an asset. (See What is the difference between amortization and depreciation? to learn more.)

One-time cash expenses are often excluded from pro forma because they are not a regular part of operations and are therefore considered an irrelevant factor in the performance of a company's core activities. Under GAAP, however, a one-time expense is included in earnings calculations because, even though it is not a part of operations, a one-time expense is still a sum of money that exited the company and therefore decreased income.

Sometimes companies even take unsold inventory off their balance sheets when reporting pro-forma earnings. Ask yourself this: does producing that inventory cost money? Of course it does, so why should the company simply be able to write it off? It is bad management to produce goods that can't be sold, and a company's poor decisions shouldn't be erased from the financial statements. The Securities and Exchange Commission (SEC) will investigate companies suspected of trying to deceive investors in the pro-forma modification of earnings. (Read more about how companies are regulated in Compliance: The Price Companies Pay.)

This isn't to say companies are always dishonest with pro-forma earnings; pro forma doesn't mean the numbers are automatically being manipulated. But by being skeptical when reading pro-forma earnings, you may end up saving yourself big money. To evaluate the legitimacy of pro-forma earnings, be sure to look at what the excluded costs are and decide whether these costs should be considering impactful. Intangibles like depreciation and goodwill are okay to write down occasionally, but if the company is doing it every quarter, the reasons for doing so might be less than honorable. (For further reading, see Impairment Charges: The Good, The Bad and The Ugly.)

The dotcom era of the late 1990s saw some of the worst abusers of pro-forma earnings manipulations. Many Nasdaq-listed companies utilized pro-forma earnings management to report more robust pro-forma numbers. Taken cumulatively, the difference between GAAP earnings and pro-forma earnings for the dotcom sector during its heyday exceeded billions of dollars.

One of the more notable occurrences of this phenomenon is Network Associates. The company went so far as to exclude its dotcom department's operating earnings. The dotcom department wasn't making or spending pretend money, so why did the company exclude these numbers? No doubt the department was losing money and decided to hide those numbers that reflected poor company strategy from investors. (Learn about dotcom companies that made it in 5 Successful Companies That Survived The Dotcom Bubble.)

Benefits of Pro-Forma Analysis Pro-forma figures are supposed to give investors a clearer view of company operations. For some companies, pro-forma earnings provide a much more accurate view of their financial performance and outlook because of the nature of their businesses. Companies in certain industries tend to use pro-forma reporting more than others, as the impetus to report pro-forma numbers is usually a result of industry characteristics. For example, some cable and telephone companies almost never make a net operating profit because they are constantly writing down big depreciation costs.

In cases where pro-forma earnings do not include non-cash charges, investors can see what the actual cash profit is. For example, recall AOL Time Warner's massive goodwill write-off of about $54 billion in 2002 to reflect the value of AOL's merger with Time Warner in the previous year. With accounting charges nearing $100 billion, Time Warner's GAAP earnings for the year probably would not have been a very good predictor of future prospects - those extraordinary expenses would probably never occur again. Analysis of pro-forma earnings is an important exercise to undertake before considering an investment in a company that reports pro-forma numbers, so be sure to do so.

Also, when a company undergoes substantial restructuring or completes a merger, significant one-time charges can occur. These types of expenses do not compose part of the business's ongoing cost structure and therefore can unfairly weigh on short-term profit numbers. An investor concerned with valuing the long-term potential of the company would do well to analyze pro-forma earnings, which exclude these non-recurring expenses.

Pro-forma financial statements are also prepared and used by corporate managers and investment banks to assess the operating prospects for their own businesses in the future and to assist in the valuation of potential takeover targets. They are useful tools to help identify a company's core value drivers and analyze changing trends within company operations.

GAAP ManipulationAside from misusing pro-forma income statements, companies can also mislead investors by creatively classifying their income in several ways, including the following:

Operating income is not strictly defined under the GAAP because classification lines are often subject to discretion. Items that are classified into this element can be selectively chosen by management. For example, non-recurring income such as special charges, shareholder class action settlements and unusual events may be included or omitted within the metric to present a value that will please shareholders.

Sales and gross profits can also be manipulated in many ways within the constraints of the GAAP. For example, companies can classify sales as either the gross amount billed to a customer or expected amounts to be received. Furthermore, sales can also depend on whether or not shipping and handling is treated as a part of revenues. Finally, gross margins can be manipulated by moving certain expenses between SG&A and other costs of sales.

In the end, these changes create artificially higher or lower income-statement metrics that can mislead shareholders.

The Bottom LineTo sum up, pro-forma earnings are informative when official earnings are blurred by large amounts of asset depreciation and goodwill. But, when you see pro forma, it's up to you to dig deeper to see why the company is treating its earnings as such. Remember that when you read pro-forma figures, they have not undergone the same level of scrutiny as GAAP earnings and are not subject to the same level of regulation.

Although a company reporting pro forma earnings is not doing anything fraudulent or dishonest (because it does report exactly what is and what is not included), it is very important for investors to know and evaluate what went into the company's pro forma calculation, as well as to compare the pro forma figure to the GAAP figure. Often, companies can have a positive pro forma earnings figure while having a negative GAAP earnings figure.

A final cautionary note for when you are analyzing pro forma figures: because companies' definitions of pro forma vary, you must be very careful when comparing pro forma figures between different companies. If you are not aware of how the companies define their pro forma figures, you may be inadvertently comparing apples to oranges.

Do your homework and maintain a balanced perspective when reading pro-forma statements. Try to identify the key differences between GAAP earnings and pro-forma earnings and determine whether the differences are reasonable or if they are only there to make a losing company look better. You want to base your decisions on as clear a financial picture as possible.